Don’t Trust Correlations Alone

All serious students of cross-market correlations know they are not to be trusted as guides to trading.

You may have spotted the most beguiling link between one asset and another, but, all the same, never lose sight of the golden rule: correlation does not mean causality.

It’s a good time to remember that because one legacy of the financial crisis has been elevated cross-market correlation.

Investors’ tendency to lump all widely-traded markets into two camps, risk assets or safe havens, whose fortunes change hourly with crisis newsflow, is well known now.

But the camps aren’t completely fenced off. Assets can migrate, or, at least, leave their accustomed position. Look at the euro. For much of last year it traded as a standard risk asset along with other global growth proxies such as equity or commodity currencies. Its correlation with the S&P 500 index, for example, peaked out close to 0.9 in November.

However, since then, the euro-zone’s own doleful back story has taken control, wrenching the euro out of the risk asset club and into a gloomy little corner of its own. That correlation has weakened sharply.

There are other examples too of course. Germany’s rock-solid bund was once the haven asset to trump them all. It’s still pretty well correlated with investor risk appetite, of course, but, according to data from HSBC, the link isn’t as strong as it used to be.

Look at Norway’s krone. Sometimes it’s a growth proxy, as now, closely correlated with oil prices. However, at other times it can seem more like a haven, offering investor a rare, triple-A rated sanctuary.

You’d be ill advised to trade that correlation alone, but analysts at Lloyds Bank think technical analysis is now backing up correlation to give a trading cue.

“We are usually sceptical of market assumptions of long-standing correlations, especially on a cross-asset basis,” they wrote.

“While they can remain broadly in place for some time, we prefer to use technical analysis on the individual markets, rather than to assume that signals in one market will be valid for another.

With that in mind they reckon both USD/NOK and Brent crude are now giving signals for a reversal on daily charts, and that the next few weeks, at least, could see declines for both.